The time value of money is a key investing principle that will help you make better investment decisions.
The time value of money is one of the most important investing concepts and has significantly impacted how our financial systems operate. By implementing the concept into your investment strategy, you will be able to maximize your investment returns and avoid losing money.
In this post, you will learn what the time value of money is and why it is one of the core principles in investing.
The time value of money is a key investing concept that can help you to guide your investing decisions. The underlying idea of the time value of money is that money that you can invest now is worth more than money you can invest in the future.
There are multiple reasons why money is worth more now than later:
The concept of the time value of money can be explained through the theory of interest, which got developed by the American economist Irving Fisher in 1907. His theory claims that interest exists because people prefer to receive money now rather than in the future. Therefore, interest rates come from the time preference people have to own money right now and the opportunity to invest the money for future income.
Imagine someone offers you to receive $100 now or $120 in two years. Assuming a (fictional) risk-free interest rate of 10%, the $100 would earn you $10 of interest in the first year leading to a total value of $110. In the second year, the $110 would earn you $11, resulting in a total value of $121. Therefore, you would be better off taking the $100 now and earning the risk-free interest rate.
The concept of the time value of money can help guide your investment decisions. Ideally, you can always opt to receive money as soon as possible. But sometimes, you will not be able to avoid receiving your money at a later time. In these cases, it is helpful to know about factors that may negatively affect your money's value.
Several factors may impact the time value of your money:
Inflation is a process that erodes the value of your money over time and therefore reduces your purchasing power. Simply put, the value of money decreases, and consequently, you can buy fewer goods for the same amount of money.
The concept of the time value of money counteracts the negative effects of inflation as it helps maintain or increase purchasing power by investing money rather than subjecting it to the loss of value. Therefore, delaying the time at which money is received is a missed opportunity to grow the money and protect it from eroding value.
The risk-free interest rate is the theoretical interest rate of an investment that carries no risk. However, in practice, such an investment does not exist. Instead, most investors use the interest rate of the three-month U.S. Treasury bill, which is seen as one of the lowest risk investments that can be made.
You can use the current risk-free interest rate to calculate the expected time value of money for a specific investment. The outcome of your calculation will tell you what your expected return will be if you decide to make the lowest risk investment available. As a result, any asset with a higher risk has to compensate you with a higher return. Otherwise, there wouldn't be an incentive for you to invest.
However, there is a small catch: If the inflation rate is higher than the current risk-free interest rate, your money will show an increase in value when it actually loses value. Therefore, it may be necessary to take higher risks to outpace inflation in this situation.
You might never receive the money when you decide to receive money at a later date. When you lend money to a friend or family member, you cannot be confident that they will have sufficient funds to pay back the money. Similarly, a business might have gone out of business by the time you expect to receive the money.
To compensate for the risk of not receiving your money, you will usually receive interest on your money. In addition, you should define a collateral asset that you can seize if you don't get your money back. Finally, you should evaluate how trustworthy and creditworthy the person, business, or government is that will owe you money.
For private persons, you can check their credit scores or depend on your own judgment. Contrary, for companies, you should check what assets and debt they hold, how their earnings are expected to change in the future, and their creditworthiness.
Your opportunity cost is the potential benefit you receive by choosing one investment over another. Opportunity costs are difficult to calculate precisely as they often depend on future events. They can only be found by listing and comparing the pros and cons of each investment possibility.
The concept of opportunity cost is a crucial factor in why the concept of the time value of money works. After all, you will miss out on many potential benefits if you decide to receive money at a later date:
The time value of money is a fundamental principle that has shaped how our financial system works. As a result of the concept of the time value of money, lenders and investors expect to earn interest when someone borrows money as they strive to maximize the time value of their own money. At the same time, you are expected to pay someone interest when you borrow money to compensate the lender for potentially reducing the time value of their money.
Similarly, the concept of the time value of money should be fundamental to how you decide to use your money. Ideally, you should aim to maximize the returns you can achieve by investing your money. At the same time, you should keep the cost of your capital as low as possible.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.